The zero lower bound and longer-term yields

The Federal Reserve lowered its traditional monetary policy instrument, the federal funds rate, to essentially zero in December 2008. However, economic activity generally depends on interest rates with longer maturities than the overnight fed funds rate. Research shows that interest rates with maturities of two years or more were largely unconstrained by the zero lower bound until at least late 2011. This suggests that, despite the zero bound, the Fed has been able to continue conducting monetary policy through medium- and longer-term interest rates by using forward guidance and large-scale asset purchases. The Federal Reserve’s main monetary policy instrument is the federal funds rate, which is the interest rate large banks charge each other to borrow reserves overnight. The Fed’s monetary policy committee, the Federal Open Market Committee (FOMC), lowered this rate essentially to zero in December 2008. Thereafter, the FOMC turned to unconventional measures to stimulate the economy, such as large-scale purchases of longer-term government bonds and communication about the future path of the federal funds rate, a practice known as forward guidance (see Williams 2012). This Economic Letter examines how much the near-zero federal funds rate has hindered the Fed’s ability to affect longer-term interest rates.